In the seventh of a series of pieces giving legal advice to the charity and social enterprise sector, Erica Crump and Augustus Della-Porta, solicitors at Bates Wells and Braithwaite (www.bwbllp.com), answer questions on charities and trading.

Can charities trade?

Yes! Even though trading is a commercial activity charities both can and do trade. The sale of goods and services now brings in over half of the third sector's income. Trading activities range from the sale of goods such as Christmas cards and the operation of cafés and restaurants, to charging fees for courses or access to activities.

Are there any restrictions on charity trading?

Yes, there are lots of traps to watch out for. Charity law imposes restrictions on the nature and level of trading activity charities can carry out. Tax is also a potential problem – some types of trading will attract a tax bill. There are two main types of trading carried out by charities, which have very different charity law and tax implications. These are primary purpose trading and the imaginatively named non-primary purpose trading.

What is primary purpose trading?

Primary purpose trading is carried out to fulfil the charity's objectives. For example, a theatre charity selling tickets for one of its theatrical productions or an educational charity charging fees for its courses and publications. Trading where the work is carried out mainly by the charity's beneficiaries is also primary purpose trading. For example, a charity working with young people sells items that those people have made.

Makes sense. And non-primary purpose trading?

This is trading designed simply to raise funds. For example, charities which sell ready-made Christmas cards at a profit are conducting non-primary purpose trading as this is not directly linked to their objects.

My local art gallery has a café for its visitors. What kind of trading is that?

This is trading which is complementary to a charity's primary purposes. It is treated in the same way as primary purpose trading.

Surely in some cases trading comprises both primary and non-primary purpose aspects?

Indeed. A museum that sells a range of goods might have some that are connected to the charity's primary purpose, for example pamphlets relating to the exhibition, and others not so connected, such as toys or key-rings. In this case the charity is carrying on two trades: primary purpose and non-primary purpose. It must keep separate accounting records for both and reasonably calculate and divide the expenses and receipts between the two trades.

Can you explain why the distinction between primary purpose and non-primary purpose trading is so important?

Of course. Primary purpose trading is good news for charities. Generally, it can be carried out by a charity without any charity law problems, and without having to pay tax on the profits. So a charitable community centre which charges a small fee for use of its facilities is operating within the rules. However, charities engaging in primary purpose trading must be alert to the public benefit rules. They should also note that VAT may be an issue and take appropriate VAT advice.

What if a charity is carrying out non-primary purpose trading?

The Charity Commission's position is that non-primary purpose trading is permissible provided it does not involve a significant risk to the resources of the charity. Risky activity should be carried out via a trading subsidiary (see below). The profits from non-primary purpose trading are also potentially subject to tax.

So what tax exemptions are there?

Other than primary purpose trading, there is also a useful exemption which applies to "small-scale" trading. Charities can carry out non-primary purpose trading within the "annual turnover limit" in any one year without having to pay tax. The annual turnover limit is £5,000, or, if the trading turnover is more than £5,000, one quarter of the charity's total income in that year, up to a maximum of £50,000. So a charity whose total income is £50,000 can make up to £12,500 from non-primary purpose trading without worrying about tax; a charity whose income is £1m can make up to £50,000.

There is a special exemption for certain types of one-off fundraising events, such as coffee mornings and car boot sales. Finally, the Inland Revenue does not regard the sale of donated goods by charities as trading, so that can be carried out tax-free.

Are there any ways of dealing with the charity law and tax restrictions?

Yes. It is very common for charities to run trading activity via a trading subsidiary. This is a tried and tested solution to the potential tax and charity law problems.

What is a trading subsidiary?

A trading subsidiary is a non-charitable trading company. Usually it is wholly owned by the charity, meaning that the charity is its sole shareholder.

And how can it help?

Because the trading subsidiary is not in itself a charity there are no limits on how much it can trade and any commercial risks are isolated in a separate legal entity. Although the trading subsidiary's profits will be subject to corporation tax, the trading subsidiary will usually gift aid all or most of its profits to the charity. This means that the taxable profits left in the trading subsidiary are either zero or very low. So using a trading subsidiary allows the charity to trade in a tax-efficient manner.

Can the charity invest funds into the trading subsidiary?

It can, but the charity trustees must be able to justify any financial support. The trustees must ask themselves whether investing in the trading subsidiary is an appropriate investment of charity funds. This includes looking at the financial viability of both the subsidiary and its proposed trading activity, and considering how long the investment will be tied up for. It is often advisable for trustees to seek independent financial expertise.

In most cases, the investment should be made on arms' length terms, for example a loan bearing a commercial rate of interest with suitable repayment terms.